INTEREST RATE SWAPS
Interest rate swaps (IRS) are financial contracts under which the parties exchange two different streams of cash flows. The most common IRS is a fixed/ floating swap, where for an agreed period of time (the maturity) fixed payments are exchanged for payments linked to a short term interest rate index. This standard swap is sometimes referred to as a Plain Vanilla Swap. Corporates and financial institutions use swaps to manage their interest rate exposure.
Example 1. A company borrows $100m for 5 years at a fixed annual interest rate of 5%. It decides to enter into an IRS to swap its fixed 5% interest payments to floating SOFR payments. The swap contract runs for 5 years, has a notional of $100m and obliges the company to pay a floating SOFR payment in exchange for receiving 5% fixed payments. The fixed interest rate payments offset the interest payments on the loan. The result is that the company transforms its fixed rate loan to a floating rate liability.
Fig. 1. IRS cash flows over time. Fig. 2. Using an IRS transforms liability.
The floating payments references the daily SOFR fixing, an overnight collateralised lending rate. The rate is compounded daily and paid at the end of the period (market standard is annual payment on both legs, as in our example).
Who is the other party to the swap? How does the company find a counterparty who wants to pay fixed and receive floating? This is the job of investment banks, who offer swaps to its clients and offset (hedge) the resulting risk with other banks who may have the opposite position.
How are swaps traded in the market? Swaps are so-called Over The Counter (OTC) derivatives, meaning they are not traded on an exchange but as bilaterally agreed contracts. Swaps are quoted as a fixed rate one party needs to pay for a given maturity to receive SOFR. Trading desks make money by applying a bid/offer spread to the quoted rates.
What does daycount convention mean? The daycount convention (DCC) determines how an interest payment for a given period is calculated. The standard USD SOFR swap trades with annual payments and subject to the Act/360 DCC on both sides, meaning that the daycount fraction counts the actual number of days in each period and divides by 360. In a normal (not leap) year, the daycount fraction will be 365/360 = 1.0139.
What floating rate applies to the floating leg? On a standard USD IRS, the floating rate applicable to any floating rate period is the daily SOFR rate published by the NY Fed, observed daily during the interest rate period, compounded and paid in arrears (at the end of the period).
What is meant by the floating rate spread? While plain vanilla swaps trade in the market as a fixed rate against SOFR (SOFR Flat), often swaps will be structured with upfront payments, specific fixed rates and spreads (essentially small fixed payments) added to the floating side.
How are swaps documented? Swaps are normally documented with industry standard documentation, known as an ISDA Master Schedule, which includes a number of bilaterally negotiated language around termination, collateralisation etc.
What is collateralisation? Swaps traded in the interbank market are collateralised, meaning that any daily move in the mark-to-market (MTM) of the swap results in the counterparty which is out-of-the-money posting collateral (normally US Treasuries) to the opposite party.
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